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MIS 4500 (31)

Lecture 24.docx

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Management Info. Systems
MIS 4500
Pourang Irani

Lecture 24: Insurance: 1. life; 2. health; 3. property and liability  life insurance cos: i. risk objectives: to fund future policyholder benefits and claims;  looked upon as quasi-trust fund—so conservative fiduciary principles;  sensitive to change of principal loss or interruption of income;  must maintain asset valuation reserve based on NAIC quality tests; GAAP-required market valuations increase balance sheet volatility;  also fund interest-rate-sensitive liabilities: annuities and deposit- type contracts  Valuation concerns: a/l duration mismatches create risk of capital adequacy problems during periods of changing interest rates: limits risk tolerance  Reinvestment risk: ability to invest maturing assets at rates sufficient to cover the guarantee rate of annuity contracts on which no interest is paid until maturity  Credit risk: risk objectives may relate to losses caused by credit risk  Cash flow volatility: low tolerance for loss of income or delays in collecting and reinvesting cash flow from investments  competition has motivated greater risk tolerance ii. Return objectives:  policyholder reserve (BS liability of estimated pmts to policyholders) rates set by actuaries; to obtain a net interest spread to increase surplus policyholder reserves  total return is difficult as only asset side of BS would reflect resulting volatility  competitive pressures to offer competitive crediting rates  Segmentation: sub-portfolio return objectives;  need to grow surplus to support expanding business volume iii. Liquidity requirements:  disintermediation: withdrawing or borrowing against cash value; or surrendering policy for cash value; has resulted in actuaries reducing duration estimates and portfolio managers to reduce duration of portfolio  Asset marketability risk: liquidity needs limit ability to invest in private placement bonds, commercial mortgage loans, equity real estate and venture capital; also liquidity requirements for forward commitments to purchase private placement bonds or mortgages  derivatives and lines of credit have decreased liquidity requirements iv. Time horizon: traditionally the classic long-term investor, but segmentation creates unique time horizons; ALM has tended to shorten time horizon v. Tax concerns: subject to income, capital gains, etc.; focus on after-tax returns; only corporate share of income (not policyholder share) is taxable  could be tax law changes regarding deferral from inside buildup of cash values vi. Legal and regulatory factors: heavily regulated by states—permitted lines of business, product and policy forms, authorized investments; industry accounting rules and financial statement forms  Eligible investments: asset classes and quality standards; interest coverage ratios or minimum credit ratings; max allocation to common stocks (~20% in U.S.)  Prudent Investor Rule: replaced laundry lists of approved investments  Valuation methods: uniform valuation methods established and administered by NAIC vii. Unique circumstances: say company’s size and surplus position  non-life insurance cos: (including health, property, liability, marine, surety and worker’s comp): differences from life:  shorter durations; longer claim processing and payments periods  some liabilities exposed to inflation risk (but not interest rate risk directly)  liabilities are relatively uncertain in value and timing; greater operating volatility ii. underwriting (profitability) cycle: 3 to 5 yrs; resulting from adverse claims experience or periods of extremely competitive pricing (often coincide w/ business cycle and require liquidation of investments) iii. models attempt to account for: 1. underwriting cycle; 2. liability durations by product line; 3. any unique cash outflow characteristics  non-life insurance co IPS: i. Risk objectives: quasi-fiduciary role; risk of catastrophic events; current cost or replacement cost coverage: inflation risk;  Cash flow characteristics: can be erratic; low tolerance for loss of principal or diminishing investment income; (no regulatory required asset-valuation reserve); ratio of casualty insurance co’s premiums to total surplus: generally 2-to-1 or 3-to-1  Common stock holdings to surplus ratio: often self-imposed limits on common stock holdings ii. Retur
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